NY Metro Hedgefund Law & News

SEC Approves Consolidated FINRA Rules Governing Know-Your-Customer and Suitability Obligations

Effective October 7, 2010 the SEC approved FINRA’s updated know-your-customer and suitability obligations rules.

KNOW YOUR CUSTOMER

New FINRA Rule 2090 (Know Your Customer) requires firms to use “reasonable diligence,”  in regard to the opening and maintenance  of every account, to know the “essential facts” concerning every customer.

The rule explains that “essential facts” are those:

• required to effectively service the customer’s account,
• act in accordance with any special handling instructions for the account,
• understand the authority of each person acting on behalf of the customer, and
• comply with applicable laws, regulations, and rules

The know-your-customer obligation arises at the beginning of the customer-broker relationship and does not depend on whether the broker has made a recommendation.  The new rule does not specifically address orders, supervision or account opening—areas that are explicitly covered by other rules.

SUITABILITY

New FINRA Rule 2111 requires that a firm or associated person have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.

The rule further explains that a “customer’s investment profile”  includes, but is not limited to:

• the customer’s age,
• the customer’s other investments,
• the customer’s financial situation and needs
• the customer’s tax status, investment objectives,
• the customer’s investment experience,
• the customer’s investment time horizon,
• the customer’s liquidity needs,
• the customer’s risk tolerance, and
• any other information the customer may disclose in connection with such recommendation.

The new rule continues to use a broker’s “recommendation” as the triggering event for application of the rule and continues to apply a flexible “facts and circumstances” approach to determining what communications constitute such a recommendation. The new rule also applies to recommended investment strategies, clarifies the types of information that brokers must attempt to obtain and analyze, and discusses the three main suitability obligations. Finally, the new rule modifies the institutional-investor exemption in a number of ways.

Recommendations

The determination of the existence of a recommendation has always been based on the facts and circumstances of the particular case. That remains true under the new rule. Several guiding principles are relevant to determining whether a particular communication could be viewed as a recommendation for purposes of the suitability rule.

For instance, a communication’s content, context and presentation are important aspects of the inquiry. The determination of whether a “recommendation” has been made, moreover, is an objective rather than subjective inquiry.  An important factor in this regard is whether—given its content, context and manner of presentation—a particular communication from a firm or associated person to a customer reasonably would be viewed as a suggestion that the customer take action or refrain from taking action regarding a security or investment strategy. In addition, the more individually tailored the communication is to a particular customer or customers about a specific security or investment strategy, the more likely the communication will be viewed as a recommendation. Furthermore, a series of actions that may not constitute recommendations when viewed individually may amount to a recommendation when considered in the aggregate. It also makes no difference whether the communication was initiated by a person or a computer software program. These guiding principles, together with numerous litigated decisions and the facts and circumstances of any particular case, inform the determination of whether the communication is a recommendation for purposes of FINRA’s suitability rule.

Strategies

The new rule explicitly applies to recommended investment strategies involving a security or securities.  The rule emphasizes that the term “strategy” should be interpreted broadly The rule is triggered when a firm or associated person recommends a security or strategy regardless of whether the recommendation results in a transaction. Among other things, the term “strategy” would capture a broker’s explicit recommendation to hold a security or securities. The rule recognizes that customers may rely on firms’ and associated persons’ investment expertise and knowledge, and it is thus appropriate to hold firms and associated persons responsible for the recommendations that they make to customers, regardless of whether those recommendations result in transactions or generate transaction-based compensation.

However,  educational material is exempted from the new rule’s coverage - which the strategy language otherwise would cover—as long as such material does not include (standing alone or in combination with other communications) a recommendation of a particular security or securities.

Main Suitability Obligations

The new suitability rule lists in one place the three main suitability obligations: reasonable-basis, customer-specific and quantitative suitability.

Reasonable-basis suitability requires a broker to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. In general, what constitutes reasonable diligence will vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the firm’s or associated person’s familiarity with the security or investment strategy. A firm’s or associated person’s reasonable diligence must provide the firm or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy.

Customer-specific suitability requires that a broker have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile. As noted above, the new rule requires a broker to attempt to obtain and analyze a broad array of customer-specific factors.

Quantitative suitability requires a broker who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile. Factors such as turnover rate, cost-equity ratio and use of in-and-out trading in a customer’s account may provide a basis for finding that the activity at issue was excessive.

The new rule makes clear that a broker must have a firm understanding of both the product and the customer. It also makes clear that the lack of such an understanding itself violates the suitability rule.

Institutional-Investor Exemption

FINRA Rule 2111(b) provides an exemption to customer-specific suitability for recommendations to institutional customers under certain circumstances. The new exemption harmonizes the definition of institutional customer in the suitability  rule with the more common definition of “institutional account” in NASD Rule 3110(c)(4). Beyond the definitional requirements, the exemption’s main focus is whether the broker has a reasonable basis to believe the customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies, and whether the institutional customer affirmatively acknowledges that it is exercising independent judgment.

In regard to an institutional investor, a firm that satisfies the conditions of the exemption fulfils its customer-specific obligation,  but not its reasonable-basis and quantitative obligations under the suitability rule. FINRA believes that, even when institutional customers are involved, it is crucial that brokers understand the securities they recommend and that those securities are appropriate for at least some investors. FINRA also believes that it is important that a firm not recommend an unsuitable number of transactions in those circumstances where it has control over the account. FINRA emphasizes, however, that quantitative suitability generally would apply only with regard to that portion of an institutional customer’s portfolio that the firm controls and only with regard to the firm’s recommended transactions.

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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.

Nothing is this blog is intended to or may be relied upon as specific legal advice. Securities and related laws are complex and competent counsel should be consulted. Views expressed by the author in this article are his own and not those of any other person.

SEC Proposes Rule for Trade Acknowledgment and Verification of Security-Based Swap Transactions

The Securities and Exchange Commission (“SEC”) has proposed a rule governing the way in which certain security-based swap transactions are acknowledged and verified by the parties who enter into them.  See Proposed Rule, 17 CFR Part 240 (January 14, 2011).

Proposed Rule

 Under the proposed rule, security-based swap dealers and major security-based swap participants, collectively known as SBS entities, would be required to provide to their counterparties a trade acknowledgement detailing information specific to the transaction.

 The new rule, Rule 15Fi-1, gives the SEC the authority to establish standards for the confirmation and documentation of security-based swap transactions entered into by SBS entities.  The proposed rule would require SBS entities to provide their counterparties with an electronic record containing information specific to the security-based swap transaction.

 In particular, it would require an SBS entity to:

 Provide a trade acknowledgment to its counterparty in a security-based swap transaction within 15 minutes, 30 minutes or 24 hours of execution, depending on whether the transaction is executed or processed electronically.

Electronically process security-based swap transactions if the SBS Entity has the ability to do so.

Have written policies and procedures in place that are reasonably designed to obtain verification of the terms outlined in the trade acknowledgment.

 In addition, the proposed rule would:

 Specify which SBS entity is responsible for providing the trade acknowledgment.

Permit an SBS entity to satisfy the requirements of the proposed rule by processing the transaction through the facilities of a registered clearing agency.

Identify the transaction details that must be included in the trade acknowledgement.

Provide a limited exemption from the requirements of Rule 10b-10 under the Exchange Act for SBS Entities that are also brokers.

 Public Comment

 Public comments should be submitted to the SEC by February 14, 2011.

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 Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.

 

CFTC Proposes Governance Requirements, Conflicts of Interest Rules for Derivatives Clearing Organizations, Designated Contract Markets, and Swap Execution Facilities

As predicted, the rule making regarding derivatives and the alphabet soup being concomitantly created thereby are continuing unabated as 2011 gets underway.

The Commodity Futures Trading Commission (‘‘CFTC’’) has proposed regulations to further implement new statutory provisions enacted by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (‘‘Dodd- Frank Act’’).  See Governance Requirements for Derivatives Clearing Organizations, Designated Contract Markets, and Swap Execution Facilities; Additional Requirements Regarding the Mitigation of Conflicts of Interest, 17 CFR Parts 1, 37, 38, 39, and 40 (January 6, 2011). 

Specifically, the CFTC proposes certain substantive requirements on the resolution of conflicts of interest applicable to derivatives clearing organizations (‘‘DCOs’’), designated contract markets (‘‘DCMs’’), and swap execution facilities (‘‘SEFs’’). These requirements address reporting, transparency in decision-making, and limitations on use or disclosure of non-public information, among other items. 

For DCOs and DCMs, the CFTC also proposes regulations concerning governance fitness standards and the composition of governing bodies.  Finally, for publicly-traded DCMs, the CFTC proposes diversity regulations for Boards of Directors (“BoD”).

Conflicts of Interest

The CFTC proposes certain requirements related to (i) reporting, (ii) identification and mitigation of conflicts of interest, (iii) transparency of governance arrangements, and (iv) limitations on use or disclosure of non-public information.

Reporting Requirements

The CFTC proposes to mandate that each DCO, DCM, or SEF submit to the Commission within 30 days after each election of its BoD:

• A list of all members of the BoD, each committee with a composition requirement (including any Executive Committee), and each other committee that has the authority to amend or constrain the action of the BoD.

• A description of the relationship, if any, between such directors and the registered entity or the members of the registered entity (and, in each case, any affiliates thereof).

• The basis for any determination that a director qualifies as a Public Director.

• A description of how the composition of the BoD and each of the abovementioned committees allows the registered entity to comply with applicable core principles, regulations, as well as to the rules of the registered entity.

 Derivatives Clearing Organizations ("DCO's")

The CFTC proposes to require each DCO to have a Risk Management Committee (“RMC”), with at least (i) thirty-five percent public directors and (ii) ten percent customer representatives.  If a DCO would like to have greater clearing member participation in risk management, then it may cause its RMC to delegate to a subcommittee (the ‘‘RMC Subcommittee’’) decisions implicating whether (i) a product is capable of being cleared and (ii) particular entities or categories of entities are capable of performing such clearing.

Designated Contract Markets ("DCMs") and  Swap Execution Facilities ("SEFs")

The CFTC proposes to require each DCM or SEF to have (i) a ROC with all public directors and (ii) a Membership or Participation Committee with thirty-five percent public directors.

In addition to the above, the CFTC proposes to require the ROC to prepare an annual report to the BoD assessing various components of the DCM or SEF regulatory program.

Regulatory Program

The CFTC proposes to require that, as part of its regulatory program, each DCO, DCM, or SEF must establish, maintain, and enforce written procedures to:

• Identify, on an ongoing basis, existing and potential conflicts of interest.

• Make fair and non-biased decisions in the event of a conflict of interest.

Transparency Requirements

The CFTC proposes rules to require each DCO, DCM, or SEF to:

 • Make available certain information to the public and relevant authorities.

• Ensure that the information made available is current, accurate, clear and readily accessible.

• Disclose summaries of certain significant decisions.

With respect to a DCM or a SEF, significant decisions would relate to access, membership, and disciplinary procedures.  With respect to a DCO, significant decisions would relate to open access, membership, and the finding of products acceptable (or not acceptable) for clearing.  The CFTC proposes to require that the DCO specifically disclose whether (i) its BoD has rejected a recommendation or superseded an action of the RMC, or (ii) the RMC has rejected a recommendation or superseded an action of the RMC Subcommittee.

 Limitation on Use or Disclosure of Non-Public Information

The CFTC proposes to require each DCO, DCM, or SEF to establish and maintain written policies and procedures on safeguarding non- public information.  These policies and procedures must, at a minimum, preclude a DCO, DCM, or SEF owner, director, officer, or employee from using or disclosing any non-public information gained through their interest or position, absent prior written consent from the DCO, DCM, or SEF, as applicable. 

Governance

In addition to Conflicts of Interest rules, the CFTC also proposes DCO and DCM regulations on governance fitness and the composition of governing boards.  Further, the  CFTC proposes DCM regulations covering diversity of certain BoD.

Governance Fitness Requirements

The CFTC proposes to require each DCM and DCO to specify and enforce fitness standards for (i) directors, (ii) members of any Disciplinary Panel, and (iii) members of the Disciplinary Committee.  These standards shall include, at a minimum, (i) those bases for refusal to register a person under Section 8a(2) of the Commodity Exchange Act (“CEA”), and (2) the absence of a significant history of serious disciplinary offenses, such as those that would be disqualifying under §1.63 of the Commission’s regulations.

Also, the CFTC proposes to require each DCM and DCO to specify and enforce fitness standards for (i) its members and affiliates thereof, (ii) persons with direct access to the DCM or, in the case of a DCO, to its settlement and clearing activities, (iii) natural persons who, directly or indirectly, own greater than ten percent of any one class of equity interest in a DCM or DCO, and (v) parties affiliated with (A) directors, (B) members of any Disciplinary Panel, and (C) members of the Disciplinary Committee.

Further, the CFTC proposes to require each DCM and DCO to collect and verify information that supports compliance with the standards articulated above and provide that information to the Commission annually.  In addition to the above, the CFTC proposes to mandate that members and certain other persons must agree to become subject to the jurisdiction of the DCM or the DCO, as a condition of access.

Transparency Requirements

Derivatives Clearing Organizations ("DCOs"):

• Each DCO shall make available to the public, as well as relevant authorities (including the CFTC), a description of the manner in which its governance arrangements permit the consideration of the views of owners (whether voting or non-voting) and its participants, including, without limitation, clearing members and customers.

 • Such description shall include, at a minimum: the general method by which the DCO learns of the views of owners (other than through the exercise of voting power) and participants (other than through representation on the DCO BoD or any DCO committee) and the manner in which the DCO considers such views.

Composition of the Board of Directors

Designated Contract Markets ("DCMs")

The CFTC proposes to require each DCM to design and institute a process for considering the range of opinions that market participants hold with respect to (i) the functioning of an existing market (including governance arrangements) and (ii) new rules or rule amendments. 

Derivatives Clearing Organizations ("DCOs")

The CFTC is proposing to require that a DCO BoD include at least ten percent customer representatives.  However, in case the Commission decides to keep such requirement at the RMC level, the CFTC is alternatively re-proposing that the RMC (or the RMC Subcommittee) be composed of at least ten percent customer representatives.

Diversity of Designated Contract Markets ("DCM") Board of Directors

The CFTC proposes to permit each publicly-traded DCM the flexibility to determine (i) the standards by which a BoD could be deemed broad and culturally diverse, and (ii) the manner in which the DCM Board of Directors meets that standard.

The Commission proposes that each such DCM make available its diversity standards to the public and relevant authorities (including the Commission) as part of its compliance with transparency requirements.  Further, the CFTC proposes that each such DCM provide the Commission with an annual certification of the manner in which its BoD meets its diversity standards.

Public Comment

Public comments must be submitted to the CFTC by March 7, 2011.

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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.

Nothing is this blog is intended to or may be relied upon as specific legal advice. Securities and related laws are complex and competent counsel should be consulted. Views expressed by the author in this article are his own and not those of any other person.

NASAA Comment Letter on Adding “Bad Actor” Disqualifications to Rule 506 of Regulation D

Welcome to 2011. I hope it will be a great year for all my readers.

As to the topic at hand:  among the multitude  of rules Dodd-Frank is mandating that the SEC make,  is disqualification from  eligibility for Rule 506 treatment under Regulation D of any otherwise qualifying  Rule 506 offering  for prior “bad acts” of certain of the persons involved in making the offering.  In particular, the SEC is to disqualify any otherwise Rule 506 qualifying offering if  it  is participated in by  a person, of a sufficiently high level, previously convicted of a felony or misdemeanor in connection with the purchase or sale of any security, or involved in the making of any false filing with the SEC, or subject to any final order of a state financial regulator or federal banking authority barring the person from the securities industry.

In a Comment Letter by the North American Securities Administrators Association, Inc. (“NASAA”) dated November 4, 2010 the SEC was urged to beef up the disqualification considerably beyond the bare bones mandate of Dodd-Frank.

In this regard, NASAA made several points in the letter.

First, while Dodd-Frank would only have disqualified persons from making Rule 506 offerings (unlimited offering amount to Accredited Investors plus up to 35 non- Accredited Investors), NASAA urged that the disqualification should apply to all private offerings under Regulation D. NASAA was concerned that otherwise issuers could engage in “regulatory arbitrage”  by making  either (i)  a Rule 505 offering (up to $5 million to Accredited Investors plus up to 35 non-Accredited Investors) subject a different set of disqualifications which could be more favorable to the issuer or (ii) a Rule 504 offering (up to $1 Million) subject to no disqualifications whatsoever.

Second,  Dodd-Frank directed the SEC to adopt disqualification provisions substantially similar to those of Rule 262 under the Securities Act. Under 262 there are different disqualifications that apply depending on which of the following classes the person falls in: (i) issuer (ii) the issuer’s directors, officers, general partners,  10% beneficial owners, promoters and underwriters or (iii) the underwriter.  This classification method  means that not all of the disqualifications of 262 apply to each class.  So if a person, A,  in class (ii) has committed a "bad" act that applies to only class (i) or class (iii) persons  then there is no Section 262 disqualification for A. NASAA would change this so that A, and hence the Regulation D offering in which A was involved,  would be disqualified.

Third,  in a 2007 Rule Making Release the SEC would have excluded Rule 262  “bad acts” of 10% of more beneficial equity holders and officers of an issuer, among others from disqualifying a Regulation D offering.  NASAA would have the SEC adopt Regulation D disqualification provisions that include such 10% beneficial owners and officers of an issuer.

Fourth, the SEC’s 2007 Rule Making Release would also have excluded Rule 262 “bad acts” of underwriters, including broker-dealers and private placement agents, as well as partners, directors, or officers of underwriters from Regulation D disqualification. NASAA urged the SEC to include underwriters as they play “a critical role” in securities offerings.  NASAA also felt inclusion of underwriters would encourage issuers to “screen” persons selling their securities.

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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.

Nothing is this blog is intended to or may be relied upon as specific legal advice. Securities and related laws are complex and competent counsel should be consulted. Views expressed by the author in this article are his own and not those of any other person.